Is it better to pay the taxes now and have them grow tax free and withdraw them tax free in retirement (Roth) or get a tax rebate now, but pay taxes on it when you take it out (traditional IRA or 401k)?

Here is a chart to see the differences more.
401(k) IRA matrix - Wikipedia, the free encyclopedia



Or a bit of both? How do people decide what kind of plan to have? How about a family making $40K a year, or $80K, or $120K? If they all wanted to contribute 10-15% of their gross income, what would be the better plan?

Let's pretend for scenario 1 that there is an employer match of 6% on the traditional IRA/401K.

For scenario 2, there is no match.

What would you recommend in each of these income brackets for both scenarios.

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Without going into all the details of the examples given, we personally invest in the Roth. Basically, I would rather pay now (a known) then later (an unknown). I noticed when we convert some older traditional IRAs, we get hit with a pretty big capital gain all at once, so I would rather have the Roth, so if we ever sell, or whatever we choose to do, the immediate tax impact is neglible. In planning our future, I know most of everything is an unknown, I want to be prepared (who knows what healthcare will cost), so I would rather get my money and not worry about big penalties/payments. The Roth benefits are either negated or prorated after $160K/year (I think), so that's something to consider. And I never consider the max contributions, because I don't think I'll ever be in that boat, we contribute the max that we can.

The family making 40k should max out their matching (6%, 2400 on their part), and try to put 4% more in a Roth. But this might be hard, on 40k a year.

The family making 80k should max out their Roth (5k) and enough of 401k to get a match (4800k). That's about 12% of their income, if I'm doing the math right off the top of my head. The family on 120k, same idea, but they should go beyond the match to contribute 12% of their income.

For all concerned, definitely get the matching.

If no matching is concerned, I would max out the Roth first and then go to the 401k. Maxing out a Roth is well under 10% for the second two families, and might be a stretch for a family on 40k, but they would be doing great if they could manage it.

Hands down, the flexibility of the Roth IRA is the best deal going with our current tax structure. The only exception is if there is a major overhaul in the tax code (ie: the IRS is eliminated and we go to the fairtax system). There are a couple of problems with the Roth IRA, though ...

1) Taxes and tax law are never certain. The government could really mess up things a few years down the road.

2) The taxed contributions doesn't motivate many people to even open an account. If the first $1000 or $2000 was tax deductible, we'd definately see more participation.

Personally, we do a mix. I hate the idea of leaving money on the table so we take advantage of hubby's employer's traditional 401k and it's match. I also actively do anything we can to reduce our taxable income.

Here is what I'd do in your scenerios ...

All families want to contribute a maximum of 15% of their gross income.
Family A makes $40,000 a year so they will contribute $6000.
Family B makes $80,000 a year so they will contribute $12,000.
Family C makes $120,000 a year so they will contribute $18,000.

All the families have an employer sponsored 401k available that provides a 6% match without limit. For simplicity sake, I'll assume none of the families are over the age of 50 and they are married couples. Take note that no family can contribute more than $20,500 a year to retirement savings. After that they have to contribute to standard nonretirement investments.

Family C has the easiest decision to make, they can't contribute more than $15,500 to the 401k so they have to have two accounts. For them, I'd recommend putting the maximum $5000 into the Roth IRA and the balance in the employer match (which will be $10,500 plus the 6% or $630.) Since the maximum match is $930, they are leaving $300 on the table.

Family B could do the same. If they put $5000 into the Roth IRA, then the balance would be $7000 and the employer match would be $420. They'd not grab that $510 boost to their income that the employer is offering. Nor do they benefit from the reduced taxable income. If they contributed everything to the 401k, they would see their taxes reduced by $1920 ($12,000 x 16% average true tax rate.) Since they are contributing only $7000 they pay $800 more in taxes PLUS they leave $510 on the table - a penalty of $1310 just for the hope of paying less in taxes in the future. That is about 1.6% of their income but it is also alittle more than $100 a month. The decision becomes more difficult at that point.

Family A has the hardest decision to make. If they contribute everything to the 401k they get a match of $360. Additionally, they get a tax savings of approximately $960 (probably less since their true tax rate is less but for simplicity sake I'll keep the percentage at 16%.) By contributing everything to the 401k they slightly reduce their financial flexibility but boost their assets by $1320 or 3.3% or their gross income. Many people would love to have a 3% raise right now. And at their income level, $100 a month means a lot more than it does to the family that is making $80k a year.

If Family A contributes the maximum to the Roth IRA ($5000), they only have $1000 to contribute to the 401k. The $1000 gives them a pitzy $60 match (leaving $300 on the table). They only save $160 on their taxes (as opposed to $960 so they end up spending $800 to save for retirement.) In other words by contributing primarily to the Roth IRA, they lose out on $1100 a year or 2.75% of their annual income which is significant.

What if Family A splits their contributions 50/50? They leave $180 on the 401k table. They pay $480 more in taxes. Thats a total of $660 or 1.6% of their annual income that they 'spend' to gain flexibility in the future.

With Family A, I tend to look at human nature and recommend that they contribute solely to the 401k. This avoids the temptation to not contribute the maximum because the money is taken out before the the paycheck arrives. Also the retirement money is less likely to be spent prior to retirement. However, it Family A is unusually self disciplined, I'd have them do the 50/50 plan.

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"Poor people work for their money. Rich people make their money work for them."

Is the employers match only $630?

My understanding on the way most 401K employer matchs work was it was a dollar for dollar match up to 6% of your salary. For instance if you make $50,000 a year and your employer will match 6% of your contribution and you contribute 6% its as if you were putting away 12% of your salary (or $6,000 a year -- you only get the employer match after you vest)

My husbands 401K has always worked like that in the last three companies he was with EXECPT they only match a half percent for each percent contributed up to a total of the 6% proposed here. So (using our fake numbers becauce I WISH they matched 6% we only get 4%) my husband has to put in 12 % of his salary and his employer adds the other 6% so its like he is saving 18% of his salary to the 401K.

I don't know much about the ROTH IRA and its tax advantages, but I am going to learn once we stop the CC debt cycle we are on!!

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Grace

Wife to Stoney

Mommy of Sarah (8.5), Hannah (7), and John(4.5)

From what I understand, ROTH IRAs only have a tax advantage if you think you will be in a higher tax bracket than you currently are when you retire. Most of us assume that we will be in a higher tax bracket because of earning more, getting raises, etc along our careers. If you don't think you will be, or if you think you will actually be in a lower tax bracket than you currently are, it makes more sense to put it in tax-deferred accounts like a 401(k) to reduce your tax burden NOW.

The big unknown in all of this will be the tax rates when we retire. That is the allure of the Roth. The way our government is spending now, we may very well see 50% as the cap rather than 38% sometime down the road. Of course, I could also see the government screwing those with a Roth by changing the legislation at some point in the future to add taxes to it at the time of withdrawal.

These are great answers. I am learning so much.

Is the $5000 cap per year for Roth per family or per individual?

I am thinking we'll be making about the same in retirement than we do now but it really depends on how our investments do over the decades. So much us unknown.

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I wanted to add that I would ALWAYS fund a 401(k) up to the match. It is free and an immediate return on your money. That is what most financial planners (including Dave Ramsey) recommend. It is only after you have maxed out your matching funds that you start funding the Roth. If there is no match, max out your Roth first if you are in a lower tax bracket. Higher tax brackets have to see about the tax-deferred trade-off.

The way LawDawg has described it is the way that every 401(k) I have had works with the matching, not the way that Cookie2 described it, although each plan is different.

Maxing out the match, here is what the families should do in my opinion, saving 15% of gross (all with up to 6% of salary dollar for dollar match). these are 2008 numbers, assuming a family with at least a husband and wife. $10,000 is the max Roth for a married couple filing jointly (that has to be 2 separate accounts, max of $5000 for an individual), with a $15,500 max for each 401(k) participant.

Family A: $40,000 ($6000 to their retirement)

They contribute 6% ($2400) to their 401(k), get a match of 100% (another $2400)from their employer, and put the balance on a Roth ($3600).

total in retirement at end of the year (401k plus Roth): $8400 (21%)

their taxable income for the year: $37,600.

Family B: $80,000 ($12,000 to their retirement)

They contribute $4800 to their 401(k), get a match of 100% (another $4800)from their employer, and put the balance on 2 Roths ($7200).

total in retirement at end of the year (401k plus Roth): $16,800 (21%)

Their taxable income for the year: $75,200.

Family C: $120,000 ($18,000 to their retirement)

They contribute $7200 to their 401(k), get a match of 100% (another $7200)from their employer, and put the max on 2 Roths ($10,000)--then put the remaining $800 back on the 401(k).

total in retirement at the end of the year (401k plus Roth): $25,200 (21%)

Their taxable income for the year: $112,000.

Family C should also look at whether or not they would rather reduce their tax burden NOW by putting the whole $18000 into 2 401(k)s. This assumes that both spouses work and have 401(k)s.

But if we don't have the option of a 401(k), then a Roth is the way to go, right?

Here is what the familie would have if they put the money first into a Roth, then the 401(k) with zero matching from the company.

Family A: $40,000 annually ($6000 in retirement)

Puts all of the $6000 into 2 Roths.

Total in retirement at the end of the year: $6,000 (15%)

Taxable income: $40,000.

Family B: $80,000 annually ($12,000 in retirement)

Maxes out 2 roths ($10,000), then puts $2000 into the non-matching 401k.

total in retirement at the end of the year: $12,000 (15%)

Taxable income: $78,000.

Family C: $120,000 annually ($18,000 toward retirement)

Maxes out 2 Roths ($10,000), then puts $8000 into 401(k).

total in retirement at the end of the year: $18000 (15%)

Taxable income: $112,000.


So, as you can see, your tax situation and your company's matching policy has a lot to do with your personal choices and how much you end up with. I will try the next one with a 6% match, but maxing out the Roth first.